People often ask: ‘Don’t you know what is going on there?’ when they see 20% of the Allan Gray Africa ex-South Africa Equity Fund is invested in Zimbabwean equities. The reason they ask this is that they are too polite to question my sanity.
The economic and political situation is no doubt very difficult in Zimbabwe and may stay that way for a few years yet. But the great thing for equity investors is the short term does not matter much when determining a business’s value, as long as the business can survive the short term. This is particularly pertinent for a leveraged business.
Bad news creates opportunities
For an equity investor, the importance of short-term news and economic cycles is that these events create opportunities to buy companies for less than they are worth, as investors with short time horizons exit. The seemingly simple trick of long-term wealth creation is to invest consistently in assets that are trading at a discount to what they are worth and to avoid those trading at a premium. We think a few of these opportunities exist in Zimbabwe.
The Zimbabwean risks include the possibility of nationalisation, higher tax rates, a liquidity crisis, a shrinking economy, flight of skills, deteriorating infrastructure, obstructive officials and the return of the Zimbabwean dollar. The good thing is that these risks are well known, to the extent that some investors avoid Zimbabwean equities totally as they do not want to deal with the uncertainties. The obvious risks give us the opportunity to invest in high-quality businesses at valuations that are unheard of in the rest of the world, with the possible exception of Russia. Of course, there is a chance that we are wrong and these companies are in fact overpriced. This will be the case if, rather than the economy stumbling along as we expect, there is an economic collapse similar to the 2000 to 2008 period. We are willing to take this risk. A total economic collapse is unlikely as this is what led to ZANU-PF losing popularity and the election in 2008. When there is no money for the people there is also a lot less money for the politicians – something they want to avoid. In the case of an extreme downside scenario we own quality industrial businesses with little debt that should retain some value.
If, rather than collapsing, the economy defies the critics and begins to recover or even remains stable, which is the more likely path from rock bottom, our investments should perform nicely. There are a lot of things that could go right for Zimbabwe, including a continuation of the recovery in agricultural production, increasing platinum production at higher platinum prices and some kind of resumption in donor funding.
The weak economy and tight liquidity situation can actually play into the hands of well-capitalised, established businesses as the barriers to entry become very high. Dollar funding in Zimbabwe costs about 14%, so any new entrants must fund their expansions with equity and the difficult conditions deter many potential competitors from even trying.
The situation in Nigeria is very different
Corporates are generally very keen on the Nigerian consumer story and are investing capital to meet the expected demand; this can reduce returns for all players. A good example is the beer industry and Guinness Nigeria in particular. The highly rated Guinness has seen its return on capital fall from 40% in 2010 to 22% currently – still a very high number, but nonetheless a disappointment for investors. This is not to say we are not finding opportunities in Nigeria; we are. However, the risk of buying a company where earnings are unsustainably high because of temporarily weak competition is a much harder risk to identify than the plainly obvious risks in Zimbabwe. For this reason, investors sometimes overpay for companies when everything is going well and there are no clouds on the horizon. Investing in a stock that is priced for perfection can lead to a permanent capital loss as the stock is re-priced from overvalued to fair value.
I far prefer to invest in companies where things are dire and the dire scenario is expected to persist. This way time and valuation are on your side. With time, very bad economic situations usually improve: witness the US and Europe in 2009/2010. If a business is struggling, a return to normality usually results in share price appreciation.
A closer look at specific investments
Our largest Zimbabwean investment is Econet Wireless, the country’s dominant mobile phone operator with a 66% subscriber share and a larger share of revenue. If Econet was a runof-the-mill mobile operator in a fairly competitive market, the valuation of eight times historic earnings would be attractive. Fortunately for investors, the company offers much more than that. The mobile phone industry is one where scale counts and the dominant operator is usually able to generate better-than-market returns. This makes sense, as the cost of serving additional customers is marginal on an established infrastructure base. Econet has invested capital of US$900m since 2010, distancing its network from those of its two competitors. The two smaller operators have struggled to generate the cash flow required to make substantial capital investments. The very high cost of debt funding in Zimbabwe means operating cash flow is required for capital investment.
Globally, in order to increase revenue, mobile operators try to offer their customers additional products and services over and above the traditional voice service, especially those services that deter switching to competitor networks. The best example of this strategy in Africa is Safaricom in Kenya, which enjoys a 75% revenue share and almost no subscriber churn among its important high-value subscribers. Interestingly, Safaricom’s churn has not increased despite the fact that it raised tariffs, a move the competitors did not follow. Safaricom has a very loyal customer base because of the superior network coverage that comes with its ability to invest capital, and M-Pesa, its very popular mobile money system. Investors have recently realised the power and potential of M-Pesa and rerated the Safaricom share price accordingly. Safaricom trades on 22 times historic earnings – a very high multiple for an established mobile operator.
In Econet Wireless’s mobile money platform, EcoCash, we see all the ingredients of a potentially successful mobile money system. Zimbabwean banking penetration is low and the transaction costs are high. Additionally, there is a shortage of coinage in the economy so receiving change for purchases is difficult. Econet’s high market share means customers are able to transfer money to two-thirds of the population. These factors should play into Econet’s hands and enable EcoCash to achieve scale, generating additional revenue and driving subscriber loyalty. Econet management are very aware of the potential and are working to realise it.
What could make EcoCash a superior product to M-Pesa is that Econet owns a bank, which makes it possible to offer clients more functionality. After three years EcoCash Save has 1.5 million account holders, compared to the total clients of the Zimbabwean banking system of 0.85 million.
We think Econet’s growth potential and dominant market position deserve a substantially higher multiple than the current eight. As always, we measure the obvious risks of investing in Zimbabwe against the potential of earning a good return for our clients.
Andrew Lapping is the fund manager of the Allan Gray Africa ex-SA Equity Fund.